Monday, September 21, 2009

The Problem With Saving

As many taxi drivers will tell you, the problem with the economy is we got ourselves into too much debt. - Too much personal debt, too much corporate debt and too much government debt.So since debt is such an intrinsic part of the current crisis, it is perhaps counter intuitive to explain why debt is not always bad and a rise in savings may create problems as well as benefits.

As this graph shows, saving ratios fell since 1995. Even adjusted for inflation, the saving ratio fell to record levels in 2008. The graph also shows the decline in personal wealth - mostly linked to falling house prices and to a lesser extent falling stock markets.

However, the factors that caused a fall in the savings ratio have been reversed and the savings ratio is likely to rise sharply over the next few months / years.

These factors include:

Greater uncertainty over unemployment. Fear of unemployment encourages people to save as a precautionary measure

Lower asset value. The fall in house prices since 2007, increases the incentive to save. Generally, when wealth rises people feel more confident to spend and borrow against the value of their house.

Tougher Credit conditions. Banks are less willing to lend and stricter about lending mortgages.

Expectation of higher taxes in the future to reduce government borrowing.

One factor that caused a fall in the savings ratio in the mid 2000s is a low real interest rate. At the moment, this is one factor that shouldn't be encouraging a rise in savings. With interest rates at 0.5% and CPI inflation at 1.6%, the interest rate gives little incentive to save.

The concern the Bank of England has is that households could reduce their consumption too much. Consumption accounts for 75% of aggregate demand, a general rise in saving against a backdrop of stagnant real wages, could keep the economy stagnating for many months. A weak recovery would mean tax revenues struggle to pick up.

Monetary policy and fiscal policy will not be trying to prevent a rise in savings and the paying down of debt. But, it will try to smooth the readjustment so the correction to long term saving rates isn't too sharp when the economy is at its most vulnerable.